How to avoid Management Liability claims

by Atty. Dr. Christian Zeller

This interview was originally published by DR. MANUELA DIEHL on SEPTEMBER 22, 2020. Read the original German here.

Dr. Christian Hendrik Zeller is a partner in the law firm ZELLER & SEYFERT Attorneys at Law Partnership mbB. In this interview, he talks about the increase in claims for damages against board members and managing directors, as desired by the legislature.


It is often said, "Managers have one foot in jail." How much truth is there in this statement?


Dr. Zeller: There is indeed a kernel of truth in this lurid exaggeration. The process of coming to terms with economic failures in companies is increasingly taking place - also - by means of criminal law. The criminal courts are imposing strict requirements, particularly on the behavioral obligations of managers with regard to the company's assets. For example, in the decision of the 5th Criminal Senate of the Federal Court of Justice on October 12th, 2016 (5 StR 134/15) it was ruled that a breach of duties under company law automatically constitutes a breach of duty within the meaning of the criminal offense of breach of trust (Section 266 StGB). In response to your initial question, it can thus be stated that the risk of a manager being prosecuted under criminal law for misconduct in connection with his professional activities has increased significantly in recent years. Even though in practice most proceedings end with fines or suspended sentences that do not directly lead to imprisonment, in the case of a suspended prison sentence one is of course metaphorically only one "further misstep" away from prison.


What consequences within the purview of criminal law can management liability have?


Dr. Zeller: Management errors can lead to criminal investigations and also criminal convictions. The potential criminal standards that can be violated in the course of a management activity can vary. They range from corruption offenses that attract media attention and crimes against the assets of the company or third parties, such as fraud, embezzlement or breach of trust, to insolvency offenses, the frequency of which will certainly increase in the near future against the backdrop of the coronavirus pandemic. Keyword "Corona": Subsidy fraud in connection with emergency aid or Kurzarbeitergeld (short-time working allowance) is also very likely to be the subject of more frequent investigations by criminal prosecution authorities in the coming months.


Penalties include fines and imprisonment, which may be suspended. The basis for sentencing is the guilt of the offender. In addition, the court must weigh the various circumstances that speak for and against the offender as a result of the specific commission of the offense. The court also takes the consequences of a sentence for the offender's future life into account. Depending on the individual case, the sentence can therefore range from a small fine to a long prison sentence.


Under what circumstances are executives and managers liable for damages?


Dr. Zeller: Managers generally owe the duty of care of a "prudent and conscientious businessman. If they violate their duty of care intentionally or negligently, they are liable for the damage incurred. In the case of manager liability—in contrast to numerous other liability cases—the special feature of the reversed burden of presentation and proof must be observed. This reversal means that in the event of a dispute, it is not the company that must prove the manager's breach of duty, but rather the manager who must prove that he properly fulfilled his duties. This makes it considerably more difficult for him to defend himself against claims for damages. A further complication arises from the fact that proof of exoneration must be provided in part for alleged misconduct that may be more than five years in the past, at a time when the manager is regularly cut off from all corporate resources. On the other hand, managers benefit from the so-called business judgment rule when evaluating their forecasting decisions. According to this judgment principle, the manager acts dutifully if he has informed himself appropriately before making his decision, has complied with legal and internal company requirements, does not act in his own interest, is not exposed to any conflict of interest, and trusts that he is acting in the best interests of his company.


How often do management liability claims actually arise in reality?


Dr. Zeller: In the last 10 to 15 years, the number of cases in the area of management liability has grown quite significantly, in some cases by double-digit percentages compared to previous years. This development can be attributed to various factors.


The initial spark for an increasing number of internal claims was triggered by the Federal Court of Justice with its landmark decision in 1997 (BGH, ruling of April 21, 1997 - II ZR175/95). In this decision, it was established that supervisory boards are fundamentally obliged to make claims against management boards in the event of breaches of duty. An exception may only be made to this if there are substantial reasons for the company’s welfare to the contrary and, at the same time, the reasons in favor of legal action outweigh or are at least equivalent to them. Further supreme court decisions with a similar impact followed, which in turn prompted the legislature in subsequent years to seek to bring about more control, transparency and publicity in the corporate sector through stricter statutory requirements.


This legislative and judicial framework has led to the widespread establishment of relatively well-functioning corporate governance rules and compliance systems, initially in large companies and subsequently also in SMEs, with the help of which violations of the law are better documented and easier to identify. Optimizing corporate structures in this way also makes it easier to uncover management errors, which then become liability cases—insofar as the prerequisites are met.


The development described above has also encouraged the spread of Directors-and-Officers (D&O) insurance in Germany, which appears to have lowered the inhibitions to managers being held liable by supervisory bodies and shareholders.


Apart from this, a narrowing of the legal scope of action for board members and managing directors can be seen in numerous legal areas. As an example, I would like to mention the European Data Protection Regulation (EU-DSGVO), which has been in force for two years now and whose mandatory requirements affect most companies to a greater or lesser extent. Increasingly high fines—similar to those imposed for antitrust violations—are being imposed for infringements. Another example is the reporting obligations in connection with the Money Laundering Act and the Transparency Register, which apply to all companies and in many cases trigger obligations for decision-makers to take action.


How can managers best protect themselves?


Dr. Zeller: A manager should take precautions against liability claims on several levels: This begins with clean documentation of all business transactions and the respective basis for decisions. If there is sufficient negotiating power, amendments to the articles of association and forward-looking drafting of employment contracts can be used to limit the standard of fault to intent and gross negligence by excluding simple negligence. In the same way, the statute of limitations can be shortened and, under certain circumstances, an upper liability limit can be set. In the case of stock corporations and limited liability companies with co-determination, however, this only works within narrow limits or not at all. If a company has several managers, it is advisable to divide up their areas of responsibility, which leads to monitoring focus areas for individual managers, as well as a risk-limiting company organization (for example, the rules of procedure that enforce institutionalized exchange or regular mandatory training in areas with high liability). With regard to individual cases, the manager can of course relieve himself by involving his supervisory body or the shareholders in the general meeting or the shareholders' meeting beforehand—or, if necessary, afterwards—whereby good preparation and a certain amount of skill may be necessary, especially in the second case. Otherwise, it helps to rely on external consultants with the appropriate specialization in certain situations, to completely outsource individual high-risk areas of activity and to ensure the most comprehensive insurance coverage possible.


How well do insurance solutions protect?


Dr. Zeller: Generally speaking, many problems can be mitigated with insurance solutions. But it's even better to start earlier and prevent them from arising in the first place. Insurance can only partially do that.


When you talk about insurance solutions, this includes D&O insurance, which insures the members of the executive bodies of a limited liability company, stock corporation or cooperative, in particular managing directors, board members, supervisory board members and advisory board members, in the event that claims are made against them by the company or third parties due to a breach of duty. It is also possible to include executive employees in the insurance coverage. In addition, it is often advisable to take out special legal protection insurance that covers criminal law, for example. On the other hand, the company can take out pecuniary loss liability insurance with the aim of protecting itself as much as possible against damage to itself and third parties, which can lead to the decision-makers not being held liable in the first place.


Insurance solutions are also an option in the case of agreed exclusions of liability, as such waiver agreements are subject to legal limits. For example, liability claims for breach of the obligation to increase capital or for inadmissible payments after the company has become insolvent cannot be excluded (§ 64 of the German Limited Liability Companies Act GmbHG). In practice, payments are often made after the company has become insolvent or over-indebted. In these cases, claims are regularly made against managing directors by insolvency administrators. Members of the management board of a stock corporation are also more comprehensively protected by D&O insurance because internal liability is stipulated in § 93 (1) AktG.


However, the (supposed) existence of insurance coverage can also lead managers to lull themselves into a false sense of security: It is not uncommon for insurers to invoke exclusions. Particularly in the case of major loss events, an insurance company must, understandably, examine every possibility of evading its obligation to pay in a specific case. For this reason, the insurance solution must never be a manager's only protective measure against liability claims.


Dr. Zeller, thank you very much for the interview.

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